Micro-finance and Poverty Alleviation

Most poor people manage to mobilize resources to develop their enterprises and their dwellings
slowly over time. Financial services could enable the poor to leverage their initiative,
accelarating the process of building incomes, assets and economic security. However,
conventional finance institutions seldom lend down-market to serve the needs of low-income
families and women-headed households. They are very often denied access to credit for any
purpose, making the discussion of the level of interest rate and other terms of finance irrelevant.
Therefore the fundamental problem is not so much of unaffordable terms of loan as the lack of
access to credit itself (Kim 1995).

The lack of access to credit for the poor is attributable to practical difficulties arising from the
discrepancy between the mode of operation followed by financial institutions and the economic
characteristics and financing needs of low-income households. For example, commercial lending
institutions require that borrowers have a stable source of income out of which principal and
interest can be paid back according to the agreed terms. However, the income of many self
employed households is not stable, regardless of its size. A large number of small loans are
needed to serve the poor, but lenders prefer dealing with large loans in small numbers to
minimize administration costs. They also look for collateral with a clear title - which many low-
income households do not have. In addition bankers tend to consider low income households a
bad risk imposing exceedingly high information monitoring costs on operation.

Over the last ten years, however, successful experiences in providing finance to small
entrepreneur and producers demonstrate that poor people, when given access to responsive and
timely financial services at market rates, repay their loans and use the proceeds to increase their
income and assets. This is not surprising since the only realistic alternative for them is to borrow
from informal market at an interest much higher than market rates. Community banks, NGOs
and grassroot savings and credit groups around the world have shown that these microenterprise
loans can be profitable for borrowers and for the lenders, making microfinance one of the most
effective poverty reducing strategies.

To the extent that microfinance institutions become financially viable, self sustaining, and
integral to the communities in which they operate, they have the potential to attract more
resources and expand services to clients. Despite the success of microfinance institutions, only
about 2% of world's roughly 500 million small entrepreneur is estimated to have access to
financial services (Barry et al. 1996). Although there is demand for credit by poor and women at
market interest rates, the volume of financial transaction of microfinance institution must reach a
certain level before their financial operation becomes self sustaining. In other words, although
microfinance offers a promising institutional structure to provide access to credit to the poor, the
scale problem needs to be resolved so that it can reach the vast majority of potential customers
who demand access to credit at market rates. The question then is how microenterprise lending
geared to providing short term capital to small businesses in the informal sector can be sustained
as an integral part of the financial sector and how their financial services can be further expanded
using the principles, standards and modalities that have proven to be effective.
To be successful, financial intermediaries that provide services and generate domestic resources
must have the capacity to meet high performance standards. They must achieve excellent
repayments and provide access to clients. And they must build toward operating and financial
self-sufficiency and expanding client reach. In order to do so, microfinance institutions need to
find ways to cut down on their administrative costs and also to broaden their resource base. Cost
reductions can be achieved through simplified and decentralized loan application, approval and
collection processes, for instance, through group loans which give borrowers responsibilities for
much of the loan application process, allow the loan officers to handle many more clients and
hencee reduce costs (Otero et al. 1994).

Microfinance institutions can broaden their resource base by mobilizing savings, accessing
capital markets, loan funds and effective institutional development support. A logical way to tap
capital market is securitization through a corporation that purchases loans made by
microenterprise institutions with the funds raised through the bonds issuance on the capital
market. There is atleast one pilot attempt to securitize microfinance portfolio along these lines in
Ecuador. As an alternative, BancoSol of Bolivia issued a certificate of deposit which are traded
in Bolivian stock exchange. In 1994, it also issued certificates of deposit in the U.S. (Churchill
1996). The Foundation for Cooperation and Development of Paraguay issued bonds to raise
capital for microenterprise lending (Grameen Trust 1995).

Savings facilities make large scale lending operations possible. On the other hand, studies also
show that the poor operating in the informal sector do save, although not in financial assets, and
hence value access to client-friendly savings service at least as much access to credit. Savings
mobilization also makes financial instituttions accontable to local shareholders. Therefore,
adequate savings facilities both serve the demand for financial services by the customers and
fulfil an important requirement of financial sustainability to the lenders. Microfinance
institutions can either provide savings services directly through deposit taking or make
arrangements with other financial institutions to provide savings facilities to tap small savings in
a flexible manner (Barry 1995).

Convenience of location, positive real rate of return, liquidity, and security of savings are
essential ingradients of successful savings mobilization (Christen et al. 1994).

Once microfinance institutions are engaged in deposit taking in order to mobilize household
savings, they become financial intermediaries. Consequently, prudential financial regulations
become necessary to ensure the solvency and financial soundness of the institution and to protect
the depositors. However, excessive regulations that do not consider the nature of microfinance
institution and their operation can hamper their viability. In view of small loan size, microfinance
institutions should be subjected to a minimum capital requirement which is lower than that
applicable to commercial banks. On the other hand, a more stringent capital adequacy rate (the
ratio between capital and risk assets) should be maintained because microfinance institutions
provide uncollateralized loans.

Governments should provide an enabling legal and regulatory framework which encourages the
development of a range of institutions and allows them to operate as recognized financial
intermediaries subject to simple supervisory and reporting requirements. Usury laws should be
repelled or relaxed and microfinance institutions should be given freedom of setting interest rates
and fees in order to cover operating and finance costs from interest revenues within a reasonable
amount of time. Government could also facilitate the process of transition to a sustainable level
of operation by providing support to the lending institutions in their early stage of development
through credit enhancement mechanisms or subsidies.

One way of expanding the successful operation of microfinance institutions in the informal
sector is through strengthened linkages with their formal sector counterparts. A mutually
beneficial partnership should be based on comparative strengths of each sectors. Informal sector
microfinance institutions have comparative advantage in terms of small transaction costs
achieved through adaptability and flexibility of operations (Ghate et al. 1992). They are better
equipped to deal with credit assessment of the urban poor and hence to absorb the transaction
costs associated with loan processing. On the other hand, formal sector institutions have access
to broader resource-base and high leverage through deposit mobilization (Christen et al. 1994).

Therefore, formal sector finance institutions could form a joint venture with informal sector
institutions in which the former provide funds in the form of equity and the later extends savings
and loan facilities to the urban poor. Another form of partenership can involve the formal sector
institutions refinancing loans made by the informal sector lenders. Under these settings, the
informal sector institutions are able to tap additional resources as well as having an incentive to
exercise greater financial discipline in their management.